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29 July, 2021updated 02 Nov 2021 15:32

Is corruption a barrier to FDI? It’s complicated…

High corruption levels can put an investor off a potential destination, but if that destination offers other competitive advantages then transparency issues can be overlooked.

By Sofia Karadima

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Photo by spixel/Shutterstock.

Investors seek economic certainty and political stability when launching operations in new locations. It would therefore stand to reason that these investors would opt for locations that are not beset by corruption problems, but this is not always the case.

Investment Monitor analysis reveals that investors launch greenfield projects in locations that register both high and low scores for corruption, calling into question just how important a factor this is when it comes to foreign direct investment (FDI).

"Our analysis shows that there is a statistically significant, positive relationship between the Corruption Perception Index (CPI) score and levels of FDI,” says Glenn Barklie, chief economist at Investment Monitor and head of FDI services at GlobalData. "There are outliers, but in general, if a country has lower corruption (i.e. a higher CPI score) we should expect higher volumes of FDI."

There is a strong correlation between corruption and [a country attracting] less foreign investment, as effectively corruption acts as a tax on FDI. Phil Mason, anti-corruption specialist

Investment Monitor's analysis also shows that the majority of countries that perform poorly when it comes to CPI, especially those scoring between ten and 50, tend to attract a lower number of greenfield projects. However, those countries at the bottom of the CPI tend to have other issues that could dent FDI flows, such as low GDP per capita, higher rates of poverty and less stable governments.

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“There is a strong correlation between corruption and [a country attracting] less foreign investment, as effectively corruption acts as a tax on FDI," says Phil Mason, an anti-corruption specialist who has previously worked at the UK's Department for International Development. "Indeed, in high-growth transition countries, corruption has been identified as the most important determinant of investment growth, ahead of factors such as firm size, ownership, inflation and openness to trade,” he adds.

How corrupt are the leading FDI locations?

Investment Monitor's analysis shows that the top ten countries by greenfield FDI project numbers in 2019 contains a mix of those that score well in the CPI, such as Germany, the UK and the United Arab Emirates, as well as countries that have lower scores, such as China, India and Mexico.

While corruption scores can be a key indicator for site selection, investors also take other factors into account when seeking a new location in which to establish operations, such as the size of the market, the geographic location and growth potential.

This explains why, for example, investors have been drawn to China, as it has a large internal market and rising global status. In addition to this, China (and India) are expected to be among the world's fastest-growing major economies in 2022. Given their high growth potential and low-cost operations and labour, there are far too many pull factors in both countries for corruption to become a prominent push factor.

Another reason why a country with a poor corruption record might attract high levels of FDI is the opportunities it presents for nearshoring, which is when an investor establishes operations in a country close to its headquarters in a bid to shore up supply chains and mitigate any other risks or disruptive events. For example, Mexico is seen as a key location for US investors looking to nearshore their operations, and Bulgaria, Romania and Hungary benefit from nearshoring operations from Europe-based investors. All four of these countries score lower than 50 in the CPI.

Is corruption bad for business?

However, irrespective of the pull factors a country may offer, for the majority, having a reputation for corruption or a low score in the CPI can act as a major impediment to attracting FDI.

The level of corruption should be a larger factor in the decision-making process if an investor is looking to invest in sub-Saharan Africa or areas of Asia and the Americas. Glenn Barklie, GlobalData

“Bribery is now widely known to be a long-term burden rather than a route to commercial success," says Mason. "There is evidence that companies that indulge in bribery, far from solving their problems, are more likely to encounter harassment or demands than those that have firmly rebutted making illicit payments. Firms may show stronger initial success when paying bribes, but they become less profitable over time as additional costs incurred from these bribes are not fully recovered.”

Indeed, a study of 480 large multinational companies by Transparency International and the Chr Michelsen Institute states that "growth in sales in markets with low background risks of corruption has a greater positive effect on a firm’s profitability than sales growth in markets with high integrity risks".

Hence, Mason says that this leads to an increasing preference for making investments in countries where corruption obstacles are seen to be less prevalent.

North America and western Europe rank as the least corrupt world regions, according to the Investment Monitor analysis, based on CPI scores. The analysis also finds that sub-Saharan Africa ranks as the most corrupt region, followed by central and eastern Europe/the Commonwealth of Independent States, and Asia-Pacific.

“Corruption should, in theory, be on every investor’s mind," says Barklie. "However, if investing in western Europe or North America, for example, corruption is unlikely to rank highly in the investment decision-making process as corruption levels are expected to be low. The level of corruption should be a larger factor in the decision-making process if an investor is looking to invest in sub-Saharan Africa or areas of Asia and the Americas.”

However, it isn't just the country's record when it comes to corruption that should be taken into account, but also the sector the investment is targeting. Mason says that the industries with the worst record for corruption are defence, infrastructure and extractives.

How does corruption impact FDI?

While companies are likely to be wary of potential investment destinations with corruption problems, similarly countries should be mindful that a business looking to establish operations within its boundaries may not always bring with it the most ethical business practices.

Countries where corruption risks are high run the risk of attracting investors from countries that are less worried about bribery. Liz David Barrett, the University of Sussex

“We know that investment is really important for economic development, but we also know that some kinds of investment are better than others," says Liz David Barrett, professor of governance and integrity at University of Sussex. "Countries really need the kind of investment that brings not just money, but jobs, human capital, technology transfer and skills, as that kind of investment has a much more lasting impact in terms of building local capacity. Corruption can leave countries trapped in a bad place where they find it hard to attract that kind of investment.”

On top of this, it is important for locations to attract investors that support responsible investing and refuse to engage in activities such as paying bribes, as this can increase the corruption risks in the country.

“Countries where corruption risks are high run the risk of attracting investors from countries that are less worried about bribery," says David Barrett. "This can create a vicious circle, where you attract investment mainly from companies that are happy to pay bribes, and [then] public officials start to expect bigger and more frequent bribes from this type of investor.”

Dermot Corrigan, CEO of enterprise solutions for due diligence automation company smartKYC, says that governance is key for mitigating corruption risks. However, he adds: “There are companies that have perfectly good policies at board level, but this is not translated into action on the ground.”

FDI offers an opportunity for locations to transform the way business is done in their country, and it can help in improving corruption scores. However, for this to be done, locations need to be attractive to responsible investors that are willing, for example, to embrace the UN’s Sustainable Development Goals to give themselves a better chance of achieving sustainable economic development.

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